I HOLD THIS TRUTH TO BE SELF-EVIDENT, THAT A DEBT CRISIS CANNOT BE RESOLVED WITH MORE DEBT

Monday, March 17, 2008

From Animal Farm To Animal House

In Orwell's Animal Farm all animals are equal - except that some are more equal than others. All in the spirit of law, order and the proper functioning of society, of course. Fittingly, the animals that have chosen this role by themselves and for themselves, are the pigs.

Cut to US financial markets today. After years of swinish behavior more reminiscent of Animal House than anything else, the pigs are threatening to destroy the entire farm. As if it wasn't enough that they devoured all the "free market" food available and inundated the world with their excreta, they now wish to be put on the public trough. Truly, some businessmen believe they are more equal than others.

But do not blame the pigs; they are expected to act as swine nature dictates. The fault lies entirely with the farmers, those authorities entrusted by the people to oversee the farm because they supposedly knew better. While the pigs were rampaging and tearing the place apart, they were assuring us all that farms function best when animals are free to do as they please, guided solely by invisible hooves. No regulation, no oversight, no common sense. Oh yes, and pigs fly..

So what is to be done now? Two things:

(a) Let financial markets sort themselves out, but with rock solid backing for bank depositors, pension funds and public institutions. The public purse should not be used to bail out - directly or indirectly - speculators in hedge funds, private equity funds and the like. Those that live by the leverage sword can defend themselves or perish by credit destruction.

(b) Revamp public policy towards increasing earned income for working people.

In other words, the focus from now on should be on adding value by means of work and savings (capital formation), instead of inflating assets and borrowing.

Furthermore, we should realize that in a world already inhabited by close to 7 billion people and beset by resource depletion and environmental degradation, defending growth for growth's sake is a losing proposition. The wheels are already wobbling on the Permagrowth model; pumping harder on the accelerator is not going to make it go any faster and will likely result in a fatal crash.

Debt, and finance in general, should be left to re-size downwards to a level that better reflects the carrying capacity of our world. The Fed's current actions are shortsighted and "conservative" in the worst interpretation of the words: they are designed to artificially maintain debt at levels that myopically projects growth as far as the eye can see.

What level of resizing may be necessary? I hope not as much as at Bear Stearns, which got itself bought by Morgan at buzz-saw prices: $2 per share represents a 98% discount from its $84 book value. What scares me, though, is the statement by Morgan's CFO, who said the price reflected the risk the firm was taking, even though he was comfortable with the valuation of assets in Bear's books. It "...gives us the flexibility and margin of error that's appropriate given the speed at which the transaction came together", he said.

If it takes a 98% discount and the explicit guarantee of the Fed for a large portion of assets to buy one of the largest investment banks in the world, where should all other financial firms be trading at? ....Hello? Anyone? Is that a great big silence I hear, or the sound of credit imploding into a vacuum?

34 comments:

(b) Revamp public policy towards increasing earned income for working people.

The tide has been flowing strongly against that for a long time now ('free trade'), so I am skeptical if this is possible; do you have concrete suggestions? With FIRE being now the majority of the US economy, it would seem difficult, in this climate, to generate real wealth that would support real income growth.

FIRE is (or should be) an industry supportive of the "real" economy. That it has (had) risen to such a position of prominence is a warning sign that the debt/asset-ification of the economy reached unsustainable, bubble levels. FIRE must now devolve back to its traditional role.

I do have concrete suggestions for increasing earned income, through the creation of high value-added jobs, employed in the radical transformation of the energy regime in the US, and perhaps the rest of the world. In a way $110 oil and the Iraq/Afghanistan wars make things easier politically, if not necessarily thermodynamically.

We need the government to set the stage through a careful balance of carrot and stick, i.e. taxation, regulation and incentive policies to create the infrastructure.

A parallel could be the Eisenhower highway construction program in the early 50's. It built the infrastructure and left private industry do the rest. Auto, steel, rubber, fuel, chemicals, hotels and many more industries boomed from one single government action.

The world is a bit more complicated now systems-wise, but the basic science is astonishingly simple and has been around for centuries.

There is great big question regarding pensions, in general. The majority of the pension systems in the world, including the US, depend on generational transference of income/wealth from current workers to pensioners. This requires that populations keep rising. That's why "healthy" pension funds must have a ratio of 4 workers for every 1 pensioner.

Permagrowth has many intertwined facets and we urgently need to start building a new sustainable paradigm now, before the old one collapses. Too many "flowers of evil" spring up under extreme conditions..

Because of the exorbitant pension benefits granted to/demanded by public employees in California? More pigs at the trough?

eh:

These pension benefits were promised in order to keep taxes low and instead of wage increases for teachers. What you are seeing now is the natural result of "pay me now or pay me later (with interest). Also, California's prohibition on raising property taxes (which support schools) also contributed to the problem.

You have to think of government as a conglomeration of service-based industries. No ticky, no laundry.

I am strill trying to understand what you practically mean by "Revamp public policy towards increasing earned income for working people."

What do you define as work? Will there by some person or organization to determine what is acceptable 'work'?

Does someone who digs ditches count as a worker, but someone who designs computer chips not? What about an attorney-- you certainly have my vote to exclude all personal injury attorneys from your working tax credit proposal!

And supposing the computer chip designer earns $1,000,000/year for their 'work'? Does this level of income get preferential treatment because we define it as acceptable work? Or will there be a maximum income cut off for this 'tax credit'?

And supposing a worker decides to work 2 full time jobs to really earn and save money for his/her family? Let's further assume each job earns $500,000 so the worker earns $1,000,000/year as a result of working twice as much as everyone else, will this get the 'tax credit', or will $1,000,000/year still be too high regardless of how hard a worker works?

Will we say 'OK' to a tax credit at $1,000,000/year (if society defines it as 'real work'?) and send government 'work checkers' to verify a worker really works 2 jobs (as opposed to dividing 1 job into 2).

But would that be fair? Perhpas another worker clocks 80 hours a week (I know many attorneys that do that)-- might they complain working twice as long in 1 job is still as bad as working twice as hard thru 2 jobs...

Will we set up an organization to check that perople's productivity?... "How hard are you really working"?

Or will we focus this tax credit on 'acceptable work' as long as it has 'results'? (who will define that)

Will teachers get their 'working credit' when they earn more for directing classrooms with twice as many students? Or will the credit focus on what the test scores of the students are are?

And what about differentials for 'undesirable work'... supposing some workers punch the clock on the overnight shift (like me and lot of other emergency physicians, nurses and paramedics). If these workers earn more for nights and weekends (which no one else wants to work), will they get to keep this extra money as well? Will there be an 'upper limit' to what they keep no matter how many undesirable shifts they work?

Your proposal may sound specific to you, but to the rest of us who do work for a living and punch punch a clock and work the nights, weekends and holidays that no one else wants but need to be covered (think about it next time you call 911 for chest pain at 3 am), you plan still seems a little short on details.

I do not want to 'push back' on your proposal-- if it really make sense then great-- but ideas are cheap and this one really needs a lot more 'fleshing out'..

At the level of leverage that broker/dealers operate, even a slight move down in asset prices that cannot be immediately liquidated for cash or adequately hedged (eg CDOs) results in a TOTAL wipeout of net equity, building and all.

This is precisely what happened to BSC and why the Fed has to provide a loan of $30 billion to Morgan against BSC's portfolio of such assets.

And they now "own" 14.000 extra employees, of which it is doubtful they could use more than 2.000 or so.

Why the silence on "I do have concrete suggestions for increasing earned income, through the creation of high value-added jobs, employed in the radical transformation of the energy regime in the US"...?

..Though I am not a politician, I do have politician friends. To them I sometimes "spoonfeed" more concrete suggestions. "spoonfeed" because they are far too involved in politics to follow the real world and thus be able to translate broad ideas into actionable policy.

"They confiscated everything, even the stuff we didn't steal!"-Animal House quote that seems fitting for the panicking Wall Street elite

Regarding the increasing income proposal: Perhaps this wasn't meant as a complex accounting scenario, but more in the sense of increased quality of life ("tide comes in, all boats rise"). The GI Bill was social engineering for the betterment of the whole. India, China, and Ireland made phenomenal strides in a short period of time by ramping up math/science education opportunities. Making a Manhattan Project to be the country with the lowest crime rate, cleanest environment, and best educated populace would be worth more than having the lowest corporate tax rate.

Forgive me if I am being a little dumb, but my reading of Hells 2 statements:

1."Revamp public policy towards increasing earned income for working people"

2. "I do have concrete suggestions for increasing earned income, through the creation of high value-added jobs, employed in the radical transformation of the energy regime in the US, and perhaps the rest of the world."

to mean someone is going to see a cut in their taxes. I actually interpreted this suggestion to mean workers would either get personal tax credits or a reduction in income taxes (i.e. Dink and Thai keep more of their earned income),

In other words, the focus from now on should be on adding value by means of work and savings (capital formation), instead of inflating assets and borrowing.

Bravo! The problem is that no one is going to save when interest rates are below inflation. Bernanke has decided to take the opposite route and try to goose borrowing to bring back the happy days of runaway asset inflation.

We had both savings and growing income until the 1980s. But TPTB called rising wages "wage-price spiral" and decided to crush it.

So now we have consumption based on rising debt rather than rising income. That works (sort of) until debt maxes out. Then the whole thing collapses in a heap.

"creation of high value-added jobs, employed in the radical transformation of the energy regime in the US"

was a "War on Oil" Manhattan Project-esque focus on clean energy to both help the US economy and air quality. We tax the @#$% out of Exxon to pay for tuition for all the new scientists we'll need.

Dink and Thai may keep *less* of their earned income for a while, but we'll suck it up for the common good. We'll have less income while others learn to make more income. BTW, I'm forcing optimism on myself because I don't drink...

Funny note- In 2004 my entire 401k was in WM stock. I got mad after the election and moved it all in 2005 (Thanks W...?). I'm trying to figure out where to roll it over into an IRA. I just want return of capital. Is using it to buy land in whatever country my finger hits after spinning a globe too random? Just pathetic.

Dink, there have been other posting of Hell's where I too came away with that interpretation, but I sense Hell is saying something more than that of late-- though in truth I am not convinced he has an actual plan more than the inkings of an idea which he has not completely explored.

What is WM stock?

By the way, if you are looking for a recommendation for your IRA, I am VERY happy to recommend my own investment manager Windward Investment management . They are based in Boston Mass and their performance results are on the website (I can vouch as being all true).

I discovered them a number of years ago when I interviewed investment houses to manage my company's retirement plan assets (I am the plan's trust officer). I have been so happy with them I actually moved all my own and all my mothers assets over to them a while ago.

In fact, as I write this I remember they were the ones who originally introduced me to the idea that 'all is not well in the land of OZ' several years ago.

I can certainly vouch for their character (whatever that is worth in an unsecured blog chat world).

1."Revamp public policy towards increasing earned income for working people"

2. "I do have concrete suggestions for increasing earned income, through the creation of high value-added jobs, employed in the radical transformation of the energy regime in the US, and perhaps the rest of the world."

to mean someone is going to see a cut in their taxes. I actually interpreted this suggestion to mean workers would either get personal tax credits or a reduction in income taxes....

With all due respect, you are thinking too much like a Republican. I hope that I am not being too presumptuous when I say that H. and I think more like this statement:

(Stephen) Colbert: What made the President's speech so groundbreaking was all the new stuff we heard from the President -- like a domestic agenda. Take his proposal to fix that whole health care mess with the only proven cure-all: tax breaks.

President Bush: And for the millions of other Americans who have no health insurance at all: this deduction would help put a basic health insurance plan within their reach.

Colbert: It's simple: most people who can't afford health insurance also are too poor to owe taxes. But, if you give them a deduction from the taxes they don't owe, they can use the money they're not getting back from what they haven't given to buy health care they can't afford.

***

And that's the Word.

If you would like to watch the video, I think you can see it on my blog.

*Thanks for the Windward Inv advice. I haven't seen anything quite like it (<20 employees, 3 straightforward catagories, etc.). But that PENSCO Trust real estate IRA option fits my current irresponsible "what the hell" attitude. Of course the fees are high and there's tax hassle involved if you collect rent. But maybe I'd buy some Scottish pasture and let the goats graze for free (anything to avoid reading another sleezy prospectus).

*Colbert is a GENIUS! He and Jon Stewart are well worth buying a Tivo for.

Nothing changed today, or Sunday. The consumer cannot service their debt load, nor can the local, state or FED gov't for that matter.So we continue on with the same silly games with the in crowd thinking they can lock in their rewards and move along, maybe they can but my guess is that the apple cart can't be made upright now or in the future without some big payments either in the form of significantly lower standard of living for the average american or the wealthy will see the gov't impose strong measures to move wealth down the income stream, my guess is for a lower standard of living for most Americans.

The plan by the PTB seems clear as day now, and it involves several key aspects:

1.) "Facilitate" the folding of the smaller more troubled WS firms into the larger ones, i.e. Bear into JPM.

2.) Part of that process involves the absolute avoidance of mark to market except behind closed doors for the select few "big fish" who are designated to take part in the "orderly" liquidations.

3. Expand the range of rescue activities the Fed will engage in such that

"What's going to happen ~28 days from now when these lending instruments come due"

emergency deals are rolled over indefinitely. Put another way, emergency deals will become essentially permanent.

4.) No criminal prosecutions-which may be perhaps the most preposterous and monstrous development of all.

A problem, if not the problem with all these efforts, is that they are undermined by the simple awareness of the per share price that JPM was able to acquire Bear for, $2.00. JPM and The Fed marked Bear to market and that's the figure they came up with. Say it ain't so, Abby Joe.

Was Bear frog marched into an unfair deal? Perhaps, but if not, who is kidding who, since if such is the case, the street is undoubtedly full of other banks and broker dealers that are utterly bankrupt.

I am utterly baffled by the Bear Stearns buyout. It has been everywhere seen as a rescue of Bear. But it seems to me more critically a propping up of Chase.

Why? Because JPM is the mothership, the epicenter, the Queen Bee, of the financial derivative complex. You have seen the page from the Comptroller of the Currency stating the notional value of derivatives held by JPM at $91 trillion, far in excess of all the competitors. It’s like the US defense budget as against the rest of the world, with a fifty/fifty split.

I have tried at various times to get some kind of handle on what this consists of, but frankly have no idea. My vague sense is that it’s some kind of bundle of the contracts, in all their diversity, that one can find at Markit.

Now the great thing that seems utterly impossible to me is that a big fat bureaucracy could sit on top of this big pile of futures, options, and forwards, while levered at 74 to 1, in the midst of astonishing volatility, and without foreseeing the gravity of the crisis, and come out without staggering losses. Maybe I exaggerate. Whatever JPM’s derivative complex consists of, surely it’s not like the Carlyle fund’s 32-to-1 leverage based on the spread between government and agency debt, which was just demented. But if it is not like that, then why don’t they give some kind of hint as to what it is? What we seem to have learned from the conference call is that it’s just like Bear Stearns; that’s why they’re “very comfortable” with assuming Bear’s portfolio. Should this not make the rest of us appalled?

Another thing I don’t understand is how much of the liability JPM has taken on. It seems the Fed has backstopped $30 billion, most of the mortgage related stuff. But isn’t there a lot more than that? The markets have reacted as if JPM got the building for practically nothing and had all the liabilities of the purchase (lawyers apart) covered by the Fed. This doesn’t seem possible to me.

Since I’m baffled, I don’t have a conclusion, only an intuition: that the “buyout” is more about JPM Chase than it is about Bear Stearns, and that the real book that prying eyes need to understand and that holds the key to the crisis sits on top of that $91 trillion derivative structure.

Americans simply don't have enough money to pay back the mortgage and credit-card debt they've run up...Furthermore there is little Bernanke can do about it. Bernanke claims to be a student of the great depression and the so called "lost decade" of deflation in Japan. However Japan did not have to face the overhang of massive consumer debt and global waged arbitrage that Bernanke has to face.

About Me

I was educated as a chemical engineer but spent almost my entire career in finance, particularly in money, FX and bond markets. The name stands for Hell-as-IOUs and the picture points to Quixotic endeavors.